Guðrún Johnsen, Assistant Professor at the Faculty of Business Administration and former employee of Althingi‘s Special Investigation Commission into the main causes of the failure of the banks; recently published the book Bringing Down the Banking System; Lessons from Iceland.

Dr. Johnsen tells the story of the rise and fall of the Icelandic banking system, describes the commission’s findings on the damaging effects of the holding company cross-ownership, and explains what can be learned from all this.

The book is published by the distinguished publishing house Palgrave McMillan and has received outstanding reviews:

This book delivers an urgent warning about the critical importance of controlling risk and incentives in banking. If those who benefit from risk don't bear more downside, they are likely to become reckless. When regulation and supervision fail, economies can come down, inflicting suffering on many. Iceland was extreme and the details are shocking, but similar dangers lurk everywhere, and we must tend to them before too late.
-Anat Admati, Professor of Finance and Economics at Stanford Graduate School of Business and coauthor of The Bankers' New Clothes: What's Wrong with Banking and What to Do About It.

A fascinating and nuanced account of the implosion of the Icelandic banking system in the Fall of 2008, drawing on official investigations and primary sources not previously available to outside scholars and policy-makers.
- Howell E. Jackson, James S. Reid, Jr., Professor of Law, Harvard Law School

Following are a few key notes from the book and from Dr. Johnsen's presentation at the University of Iceland:

The balance sheet of the banks, and lending, grew way out of proportions - the banks took the wrong path. In seven years, from 2000 - 2007, the banks grew 20 fold.

This development happened in an environment where free flow of capital (EEA 1995) had recently been allowed. The government banks were privatized shortly after (from 1998 - 2003). New people took control of the banks.

The new owners and managers took advantage of the large supply of loans at foreign markets, the interest rates on these loans were low and the banks had good credit ratings which the Icelandic government had built up over a long period of time.

Too much lending, financed by too much borrowing, created maturity problems, and created a great refinancing risk. Great risk was taken regarding change in conditions at foreign credit markets.

In the spring of 2006 Iceland received real warnings regarding the risks that were building up. The supply of credit for refinancing decreased, but then the two largest banks tried to collect deposits from the public in Britain and the Netherlands, using Icesave and Edge internet savings accounts.

In the fall of 2007 the risk became a reality and the markets closed. The CDS spread began to increase fast and the stock index began to decrease. The exchange rate for the Icelandic currency then began to depreciate and that continued until the summer of 2008.

Dr. Johnsen says that the banks were in fact at the end of the road during the fall (autumn) of 2007.

In addition to the Icesave and Edge deposits, the banks took loans from the Central Bank of Iceland, against insufficient collateral (so called 'love letters'). This ended up defaulting the Central Bank of Iceland. The banks did the same thing at the Central Bank of Luxembourg and sneaked Icelandic collateral's into the European Central Bank, through back doors, using tricks.

The Icelandic bank's operations were said to be international and 60% of their lending was said to be loans to foreigners. Still most of the risk of their loan portfolio was Icelandic risk - hidden behind webs of holding companies in tax havens. Cross-ownership's and webs of deception were used to hide large loans to the owners of the banks and affiliated parties.

That is how the Icelandic banks could lend to firms, that were connected to the owners of the banks, way above the legal maximum.

In the end the owners of three largest banks had taken a large share of the banks' equity and lent it to themselves, exceeding the legal maximum, through their corporations. The banks lent to firms owned by the owners of other banks, to deceive surveillance authorities.

Why did the bankers do this?

The managers of the banks received bonuses, which meant that super growth and super risk increased their income. The incentive for increased risk taking was built in.

The quality of the loan portfolio began to deteriorate fast after 2003, for example by increased bullet loans - risk increased and refinancing risk increased.

The loan portfolio of the daughter company of Landsbankinn bank in Luxembourg was mostly Icelandic risk.

A large share of the registered stocks was collateralized at the banks, including shares in the banks themselves.

To keep the stock price up the banks engaged in market manipulation from 2006 - 2008, in order to prevent the stock price from decreasing. This kept the banks alive during these years, along with collecting deposits from the public in Britain and the Netherlands, using unsustainable overbidding of interest rates. Many of the bankers have been sentenced to up to 6 years in prison for market manipulation.

The banks used financial statements for deception by not explaining the deterioration of the equity that came with market manipulation. Numbers regarding equity were in fact falsified. Auditors looked past that.

British authorities saw that the equity in branches in England was not enough to secure deposits, for Landsbankinn bank. They offered to put the branches under British financial surveillance, but then the bank would have had to increase the equity. The bank did not do this, and probably was not able to. Icelandic authorities did not offer money to help. Then the British government seized control of Landsbankinn branches in Britain, during the evening of 7th of October, 2008.

The mother company of Kaupthing bank was tapping money from Kaupthing Singer and Friedlander in London, using tricks. British authorities spotted this and decided to seize control of the bank and freeze all assets in Britain (using anti-terrorism legislation).

Even though the Icelandic government was practically debt free at the time, nobody was willing to lend to the Central Bank of Iceland - because every foreign central bank saw that the Icelandic banks were about to collapse. They pointed to the IMF for emergency help.

It was fortunate that the Central Bank of Iceland did not get loans to help the banks - if that would have happened the government debt would have been unmanageable and Iceland would have defaulted, like the Governor of the Central bank of Iceland confirmed recently at a conference about the crisis in Iceland in Ireland, that was held in Reykjavik.

Why did this go so far in Iceland?

Too weak financial supervisory authority, too weak central bank and a too weak government were the main causes. The surveillance in Iceland was completely inadequate. Fanatic-believe in unrestricted markets and hostility towards surveillance authorities was preached both by politicians and businessmen.

Employees at the central bank began to seriously worry about the banks in November 2007 - but they sent no suggestions to the government, neither formal nor informal. The central bank was however required by law to act.

After the banks fell, their assets were believed to be around 40% of their booked assets. The bubble / foam was around 60%. The assets of the banks were written off by around five fold Iceland's GDP.